Corporate Social Responsibility: A Law & Economics Perspective

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Corporate Social Responsibility: A Law & Economics Perspective

Jonathan R. Macey*

INTRODUCTION

The law and economics of corporate social responsibility are simple. Assets are worth more to their owners if they are held exclusively by those owners rather than shared. This simple fact explains why shareholders prefer to be the exclusive beneficiaries of corporate fiduciary duties. If, however, the rules of the game were changed and corporations were deemed to have responsibilities to society in general, instead of exclusively to their shareholders, the shareholders would be harmed because the economic value of their shares would decline. Of course, shareholders would agree to a change such that corporations owed duties to society rather than to the shareholders exclusively if they were compensated for this diminution in rights. Thus, if non-shareholder constituencies such as local communities, workers, suppliers, or customers valued these rights sufficiently, they would have them because they would buy them from the shareholders. The fact that this does not happen is strong evidence that it is efficient to organize corporations such that they are run so as to maximize value for shareholders.

From a law and economics perspective, the corporate social responsibility debate is really a debate about how to interpret the contracts and understandings that allocate rights and responsibilities within corporations and other forms of business organizations (hereinafter corporations), and between corporations and those located outside of the corporation, such as local communities. The ineluctable reality is that when shareholders make investments in a corporation, they do not think that they are giving their money away. Rather, they invest

* Sam Harris Professor of Corporate Law, Corporate Finance, and Securities Law, Yale Law School. This Article`s content draws in substantial part from, and includes revisions and extensions of arguments in, earlier articles, including, for example, Jonathan R. Macey & Geoffrey P. Miller, Corporate Stakeholders: A Contractual Perspective, 43 U. TORONTO L.J. 401 (1993); Jonathan R. Macey, Externalities, FirmSpecific Capital Investments and the Legal Treatment of Fundamental Corporate Changes, 1989 DUKE L.J. 173 (1989); and Jonathan R. Macey, An Economic Analysis of the Various Rationales for Making Shareholders the Exclusive Beneficiaries of Corporate Fiduciary Duties, 21 STETSON L. REV. 23 (1991).

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on the premise that they have the right to receive something in exchange for their investments. To say that corporations are supposed to be managed to maximize shareholder value is simply to recognize that part of the reciprocal promise made by the corporation in exchange for the investment is an agreement that the corporation will be managed for the benefit of the shareholders.

From this very basic perspective comes the insight that the fiduciary duties that officers and directors owe to shareholders simply reflect a central term of the standard form contract created when a corporation issues shares: the corporation is promising that the business will be run to maximize returns for shareholders. While there is some confusion on this subject, this basic contract is entirely mutable in every detail. In other words, it is the default rule that is in place unless the corporation, at its inception, chooses to make a different set of commitments to investors.

It is not entirely clear that fiduciary duties are particularly valuable assets. The fervor of the corporate social responsibility debate suggests that having the shareholders` right to have the corporation managed for their exclusive benefit, as opposed to the benefit of all stakeholders, including non-shareholder constituencies, must be worth something. Otherwise, it would not be worth fighting over.

The interests of the widely variegated groups of claimants on firms` assets conflict in numerous ways. By strengthening the bargaining position of one group, the law inevitably weakens the bargaining position of the other competing groups.

Building on the axiom that the corporation is a nexus of contracts,1 fiduciary duties are simply corporate assets that are bargained for and auctioned off among the various groups of stakeholders. The bargaining process theoretically could lead to a wide variety of outcomes.

As long as the parties engaged in the bargaining process are rational, however, they will agree to stipulate that fiduciary duties will be exclusively enjoyed by one constituency, if the value of such duties is greater when enjoyed exclusively than when shared with other groups. Thus, the allocation of fiduciary duties exclusively to one group of claimants does not reflect any lack of bargaining power on the part of the groups that do not enjoy the privilege of being the beneficiary of such duties. Rather,

1 See R.H. Coase, The Nature of the Firm, 4 ECONOMICA 386, 393 (1937) (A firm, therefore, consists of the system of relationships which comes into existence when the direction of resources is dependent on an entrepreneur.).

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I argue that these other groups benefit by giving up any claims they might have on such rights by more than they lose.

The benefits will vary depending on the nature of the nonshareholder constituency at issue. They may take the form of higher interest rates for bondholders, higher wages or greater job security for workers, or higher taxes for local communities. Thus, the notion of forbidding companies from offering a standard form contract in which shareholders are the exclusive beneficiaries of fiduciary duties and requiring firms to allow directors to serve broad societal interests will not only make shareholders worse off, they make other constituencies worse off as well.

For over a century, state corporate law doctrine provided that the directors of both public and closely held firms owe fiduciary duties to shareholders and to shareholders alone. The applicable legal norm required directors to manage a corporation for the exclusive benefit of its shareholders. Protection for other sorts of claimants existed only to the extent provided by contract. This principle has been subjected to sustained attack.2

I argue that fiduciary duties should flow to residual claimants and to residual claimants alone. This conclusion stems from a contractual analysis, under which residual claimants receive the benefits of fiduciary duties, not because other groups do not value them, but rather because (1) the aggregate value of fiduciary duties to any group within a firm diminishes as those rights are shared with other groups; and (2) the shareholders value these rights more than any other group.

Non-shareholder constituencies also value these rights. It would be surprising indeed if rights were of value to one group but not to another group, just as it would be surprising if the rights were of exactly the same value to every group. The very nature of the interests and contractual claims of non-shareholder constituencies makes it easier for these constituencies to protect themselves from post-contractual opportunism by the firm. In addition, non-shareholder constituencies already enjoy the protection provided by judicial gap-filling and do not need the additional gap-filling protections afforded by fiduciary duties. All groups ultimately benefit from a legal regime that makes shareholders the exclusive beneficiaries of fiduciary duties.

A valid criticism leveled at other constituency statutes is that they require corporate agents to serve so

2 See, e.g., Comm. on Corporate Laws, Am. Bar Ass`n, Other Constituencies Statutes: Potential for Confusion, 45 BUS. LAW. 2253, 2253 (1990) (criticizing other constituencies statutes for carrying the potential to change basic premises of corporate law).

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many masters--employees, communities, bondholders, customers, suppliers--that the costs in terms of confusion and misunderstanding on the part of courts and litigants vastly outweigh any potential benefits that such statutes might provide. But this argument is not dispositive of the debate because it ignores the fact that corporations have long been able to issue multiple classes of shares with different economic and political rights, and corporate management has owed fiduciary duties to each of these classes. Thus, it simply cannot be said that corporate law is incapable of reconciling the claims of a variety of competing interests. The argument that other constituency statutes will cause confusion also neglects the fact that most managers` actions are insulated from judicial secondguessing by the business judgment rule. Accordingly, as a practical matter, the rights being taken away from shareholders by other constituency statutes were not rights that provided much in the way of concrete benefits for shareholders in the first place.

Interestingly, over a significant range of important corporate decisions, other constituencies such as fixed claimants or workers may actually have the greatest stake in the decisions being made. For example, shareholders may well benefit by a corporate decision to close a particular plant, but the workers who would lose their jobs in that plant closing likely would suffer to a much greater extent.

Similarly, other constituency statutes cannot be condemned on the grounds that they upset a system of legal rules that present a pre-existing set of clearly defined behavioral guidelines for officers and directors. No such set of guidelines exists.

Rather, the critical problem with other constituency statutes is that they fail to recognize that fiduciary duties are owed solely to residual claimants because they are the group that faces the most severe set of contracting problems with respect to defining the nature and extent of the obligations owed to them by officers and directors. Fiduciary duties should properly be seen as a method of gap-filling in incomplete contracts. And shareholders place a far greater value on the protection provided by this gap-filling than do the other constituencies of a corporation.

This observation, of course, raises an obvious follow-up question: if gap-filling is a useful device from the shareholders` perspective, why not from the perspective of these other constituencies as well? Here I argue that under modern principles of contract law, courts do fill in gaps for these other constituencies, but they do so against the background of the pre-

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existing contracts that these groups have with the firm. Thus, gap-filling on behalf of such other constituencies as employees and bondholders is done in the context of interpreting the employment contracts, collective bargaining agreements, bond indentures, and covenants that these other groups have with the corporation. Necessary gap-filling is achieved in this context.

The obvious exception to this general rule comes from the local communities in which large corporations operate. Unlike the rest of the constituencies with which a firm deals, the local community has no preexisting agreement with the firm. As such, there simply is no gap for a court to fill. However, the local community is, or should be, well represented in the political process. Any grievance felt by the local community is best addressed to local political officials.

Finally, this paper considers--and rejects--the argument that other constituency statutes are worthwhile because they prevent inefficient wealth transfers from other constituencies, particularly bondholders and employees, to shareholders. The question is not whether such wealth transfers are theoretically possible, because they clearly are. Rather, the relevant issues are (1) whether the dangers associated with such wealth transfers can be avoided by contractually negotiated covenants between the fixed claimants and the firm; and (2) whether the social costs of attempting to mitigate this wealth transfer problem through the promulgation of other constituency statutes are greater than the social benefits. The answer to both of these questions is yes. It seems patently clear that the actual purpose and effect of these statutes is to benefit a single non-shareholder constituency, namely the top managers of publicly held corporations who want still another weapon in their arsenal of anti-takeover protective devices. In other words, like many other legislative initiatives, other constituency statutes do not benefit the interests or groups that they ostensibly are intended to benefit. Rather, such statutes benefit a well-organized, highly influential specialinterest group, namely the top managers of large, publicly held corporations who wish to terminate the market for corporate control.

I. CORPORATE SOCIAL RESPONSIBILITY AND RESIDUAL CLAIMANTS

Other constituency statutes and other efforts to require corporations to shift their focus from shareholders to society are inconsistent with the fact that shareholders` expectations of being the exclusive beneficiaries of fiduciary duties are legitimate because this is what they have contracted and paid for. This argument derives from the insight of modern financial theory

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that shareholders retain plenary authority to guide the fate of the corporate enterprise because . . . they have the greatest stake in the outcome of corporate decision-making . . . .3 Despite the fact that corporations are merely complex webs of contractual relations--and despite the fact that shareholders do not own the modern, publicly held firm in any meaningful sense--the ultimate right to guide the firm (or, more precisely, to have it guided on their behalf) is retained by the shareholders because they are the group that values it most highly.4

The implication of this analysis for the allocation of fiduciary responsibilities within the firm is not entirely clear. To say that shareholders place the highest value on the rights protected by fiduciary duties is not the same as saying that shareholders are the only group that values such rights. Clearly, many discretionary decisions within the corporation harm the rights of other claimants. For example, in recent years corporations have: (1) [r]edeem[ed] refunding-protected debt with proceeds of an equity offering, while at the same time borrowing for other corporate purposes at lower interest rates;5 (2) [d]eliberately engineer[ed] a technical default in a private debt covenant, in order to be forced` to retire a high coupon issue that was otherwise fully call-protected;6 (3) [b]orrow[ed] heavily in the short-term market, [and] then offer[ed] bondholders a choice between amending a covenant limitation on funded debt or leaving the issuer severely exposed to interest rate fluctuations and burdened with large near-term maturities;7 and (4) [l]everag[ed] . . . [their capital structure] to avoid a hostile takeover, thereby triggering a decline in the company`s bond rating . . . , notwithstanding the bondholders` longstanding assumption that the issuer desired to maintain the highest possible rating in order to minimize its borrowing costs.8

Thus, the interesting question is not why shareholders receive the benefits of fiduciary duties, but why they should be the exclusive beneficiaries of fiduciary duties, given that other constituencies would benefit if they had the rights created by the imposition of such duties. But why would shareholders, as residual claimants, place the highest value on fiduciary duties?

3 Jonathan R. Macey, Externalities, Firm-Specific Capital Investments, and the Legal Treatment of Fundamental Corporate Changes, 1989 DUKE L.J. 173, 175 (1989).

4 Id. 5 Martin S. Fridson, Bondholder Rights: A Survey of Current Issues, EXTRA CREDIT: THE JOURNAL OF HIGH YIELD BOND RESEARCH, Jan.?Feb. 1992, at 33. 6 Id. 7 Id. at 34. 8 Id.

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After all, once we accept the view that the firm is not an entity at all but a set of contracts or series of bargains:

[The organization] . . . decomposes . . . into a group of identifiable participants--e.g., investors, managers, creditors, employees and suppliers--who negotiate an equilibrium position among themselves. An implication of this perspective is to deny that any one class of participants (i.e., the shareholders) have a natural right to view themselves as owners of the firm. Rather, shareholders are seen not as the firm`s owners, but as suppliers of equity capital; they are the residual claimants,` who bring to the firm their special ability at riskbearing, which creditors, managers, and employees tend to lack.9

Of course, [o]nce we view the shareholders as simply the residual claimants who have agreed to accept a more uncertain . . . return because of their superior risk-bearing capacity, it is far from self-evident that they are necessarily entitled to control the firm,10 that is, to have managers` and directors` fiduciary duties flow exclusively to them.

The rationale for why shareholders place the highest value on such rights is said to be that,

[u]niquely, the residual claimants . . . are interested in the firm`s overall profitability, whereas creditors and managers [and presumably other constituents as well] are essentially fixed claimants who wish only to see their claims repaid and who will logically tend to resist risky activities. Having less interest in the overall economic performance of the firm, creditors can bargain through contract and do not need representation on the board to monitor all aspects of the firm`s performance.11

Thus, fiduciary duties exist because the decisions that face officers and directors of corporations are sufficiently complex and difficult to predict. It would therefore not be feasible to specify, in advance, how such officers and directors should respond to a wide range of future contingencies. Fiduciary duties are the mechanism invented by the legal system for filling in the unspecified terms of shareholders` contingent contacts. It has been argued that these duties run exclusively to shareholders because, as residual claimants, [t]he gains and losses from abnormally good or bad performance are the lot of the shareholders, whose claims stand last in line.12 As Easterbrook and Fischel have observed:

9 JESSE H. CHOPER, JOHN C. COFFEE, JR. & C. ROBERT MORRIS, JR., CASES AND MATERIALS ON CORPORATIONS 28 (3d ed. 1989).

10 Id. at 29. 11 Id. 12 Frank H. Easterbrook & Daniel R. Fischel, Voting in Corporate Law, 26 J.L. & ECON. 395, 403 (1983), available at .

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As the residual claimants, the shareholders are the group with the appropriate incentives . . . to make discretionary decisions. The firm should invest in new products, plants, etc., until the gains and costs are identical at the margin. Yet all of the actors, except the shareholders, lack the appropriate incentives. Those with fixed claims on the income stream may receive only a tiny benefit (in increased security) from the undertaking of a new project. The shareholders receive most of the marginal gains and incur most of the marginal costs. They therefore have the right incentives to exercise discretion [or to have it exercised on their behalf].13

A simple illustration can be used to demonstrate this point. Suppose that a firm has two classes of claimants: fixed and residual. The firm will owe $1 million to the fixed claimants at the end of period one. Suppose further that the firm has to choose between two projects: A and B. Both of these projects will require the firm to allocate one hundred percent of its resources to that project for the relevant period. Project A has a 0.5 chance of producing a pay-off with a present value of $1 million, and a 0.5 chance of producing a pay-off with a present value of $5 million at the end of period one. Thus, the expected present value of project A is $3 million.14 Project B, on the other hand, has a pay-off matrix in which there is a 0.5 chance of a pay-off with a present value of $6 million, and a 0.5 chance of a pay-off with a present value of $1 million. Thus, while project A has an expected value of $3 million, project B has an expected value of $3.5 million.

The shareholders will prefer project B, since they are better off by $500,000 if they select that project.15 The fixed claimants, by contrast, are indifferent as to whether the firm selects project A or project B because under either outcome available under either project, the fixed claimants are absolutely certain to obtain the $1 million that is owed to them by the firm. Where a firm is making a decision like this, the fixed claimants clearly do not deserve a role in the decision-making process. The firm, and society, are better off if the firm selects project B, because that is

13 Id. 14 (0.5 x $1 million) + (0.5 x $5 million) = $3 million. 15 Project A has an expected value to the shareholders of $2 million. If the project only makes $1 million, the fixed claimants will get all of the gains from the project, and there will be nothing left over for the shareholders. If the project makes $5 million, the shareholders will get $4 million, because the first million goes to satisfy the firm`s obligations to the fixed claimants. Thus, project A has an expected value to the shareholders of $2 million (0.5 x $4 million = $2 million). Project B has an expected value of $2.5 million. As before, if the project only makes $1 million, the shareholders get nothing. If the project makes $6 million, the shareholders will get $5 million, because the first million will go to the fixed claimants of the firm. Thus, project B has an expected value to the shareholders of $2.5 million (0.5 x $5 million = $2.5 million).

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